Despite a deal, the Cyprus debacle will deepen the depression now starting to grip the European economy. This has grown from a financial crisis to an economic crisis, and the collapse of Cyprus will make that a whole lot worse. This rescue will push Cyprus into catastrophic recession, provoking an outflow of global funds from the euro-zone.

LONDON (MarketWatch) — A deal was always likely to be done at the last minute in Cyprus.

The sums of money were too small, and the impact of the country chaotically pulling out of the euro too catastrophic, for the two sides not to be prepared to compromise. Late at night, with a deadline looming, the two sides managed to cobble together a deal. The euro staggers on for another day.

But the Cyprus debacle will deepen the depression now starting to grip the European economy. This is no longer a financial crisis — it is an economic crisis. And the collapse of Cyprus will make that a whole lot worse.

The so-called rescue will push one more country into a catastrophic recession. It will provoke an outflow of global funds from the euro-zone. And it will encourage small businesses and depositors to hoard cash. A modern economy can’t function without a healthy banking system. And after Cyprus, no bank in the euro zone can be regarded as safe anymore.

There has been a lot of nonsense written about how the Cypriot economic model was unsustainable. It turned itself into an offshore financial center, its banks stuffed with dodgy Russian money, we are told. In the German version of events — and in Germany, financial markets are always treated with suspicion — they were the authors of their own downfall. If they went broke, it was their own fault. And if they got kicked out, maybe the currency would be better off without them.

None of it was really fair. True, there was a lot of Russian money in the country’s banks. But so what? Despite what you might see in Hollywood movies, Russia is no more dominated by gangsters than many other countries. Moscow is no more corrupt than Las Vegas or Naples. Nor is there much reason to think the Russians parking their money there are dodging taxes. Tax in Russia is very low — a 13% flat-rate income tax and a 20% corporation tax. On the whole, people don’t dodge taxes that minimal — it isn’t worth the risks involved. If they were, they would have been better off paying taxes in Russia than the levies they will end up paying on their deposits in Cyprus.

In truth, banking is a very lucrative industry and there is no reason not to base an economy on it. Plenty of places have massive financial industries without being unstable. What about Switzerland, probably the most stable nation in the world? Or London or New York? Iceland blew up, but as a general rule, financial centers do well. Banking made Cyprus one of the wealthiest countries in the Mediterranean, with a GDP per capita of $30,000, about the same as Spain. If the euro crisis had not destroyed its main trading partner — Greece — and imposed huge losses on its banks it would have carried on getting richer. Since the rest of the euro zone caused the crisis there was no reason not to help it out.

Instead, the European Union and the International Monetary Fund came up with a “rescue” that will destroy the Cypriot economy. Like so many earlier euro-zone deals, it has bought short-term stability at the price of long-term disaster.

There are three big problems:

The relatively successful Cypriot economy is about to be decimated

Already there are estimates that GDP could drop 20% over the next five years. What else is to be expected? Services make up 80% of the economy, and while tourism will survive, the banking industry will not. No serious money will want to remain in the country after the saga of the past week. Maybe Cyprus is meant to build up other industries. But how exactly can it do that with a bust banking system and capital controls that will stop companies taking money out of the country?

There might be some offshore gas, as many people have speculated this week, but who will want to develop it if they can’t get their money out? North Korea probably has a friendlier business climate than Cyprus as of this week. It will join Greece, Ireland, Portugal, Spain and Italy in permanent recession. An arc of poverty and unemployment is spreading across Europe that starts in Nicosia and ends up in Dublin. As each country gets poorer it gets tougher for the rest.

The ‘rescue’ will lead to an exit of global funds from the euro zone

The euro aimed to be a global reserve currency to rival the dollar. It was making some progress towards that. For example, 42% of Russian reserves were held in euros, and they are the fourth largest in the world. They won’t be staying there. Spain is already proposing a 0.2% levy on bank accounts. Others may well follow. Becoming a global reserve currency was meant to be one of the key benefits of creating the euro — there is no chance of that now. Instead, funds will flow out, hitting the currency, and more importantly damaging investment.

Deposits are going to flee the other peripheral countries

It won’t happen overnight. Opening up a foreign bank account is actually quite difficult, unless you have a lot of money it is unlikely to be worth the bother. But individuals and companies will ultimately become more and more reluctant to hold money in the bank. They will prefer real assets instead, or they will stick to cash. That is going to hurt those economies even further and hit their wobbling banks.

It would have been far better for both Cyprus and the rest of Europe to have made some tough long-term decisions over the last weekend, and that would have meant rescuing the Cypriot banks and negotiating the country’s orderly exit from the single currency.

Markets might rally on the deal, a sudden Cypriot exit would have been a traumatic event. But the so-called rescue is still a disaster of the euro-zone economy. It was already shrinking. By the autumn it will be in a full-scale depression. And that means the euro itself and European equity markets will be falling for the rest of this year.